What is The Accounting Equation?

The accounting equation is the basis of all accounting entries that will be put through a company’s accounting system. The fundamental principle of the double entry system relies on the accounting equation being followed.

So what is the accounting equation?

The accounting equation is as follows: Assets – Liabilities = Equity.

This always works and if doesn’t it means something has gone wrong.

Why does it work?

Equity is essentially the money the owners of a business have put into the business in order for it to work. In order for our double entry system to work we imagine equity to be the money that is owed back to the owners of the business (the owners are the shareholders). This is because whenever a shareholder invests in a business they expect some form of return on their investment.

First example

If we take a very basic example, where a sole trader invests £500 in cash to start up their business, there is now £500 in equity because the owner of the business has put £500 in and there is now £500 cash in the business, which is an asset.

If we plug these numbers into the accounting equation then we get.

500 (assets) – 0 (liabilities) = 500 (equity)

500 = 500

We know this is true so the accounting equation has worked.

What about profits?

The equation becomes slightly more complex when we introduce the idea of profits and losses into the business – but do not be deterred by this.

It is important that we view the profits of a business as being the return on the shareholder’s investment. It is the amount of money the business has earned after deducting all the relevant expenses.

Lets say that out of the £500 cash, £200 is used to buy stock. All of this stock is then sold on for £400 cash creating a profit of £200.

The effect on the balance sheet of the business is as follows:

Cash – gets reduced initially by £200 to buy the stock but when the stock is sold, £400 cash comes back in. The net effect of this is that the cash increases by £200. (500 – 200 + 400= 700)

Stock – Stock increases by £200 but by the year end this has all been sold so there is zero impact on the stock balance at the year end.

Equity – Equity is increased by the £200 profit that has been generated by the business in the year. This is because the profit is effectively owed back to the shareholders and will be listed on the balance sheet as Retained Earnings. 

When this information is plugged into the equation we get the following:

700 (assets) – 0 (liabilities) = 700 (equity – (share capital + retained earnings))

700 = 700

Again, we know this to be true and thus, the equation has worked and the accounts are balanced.

Rearranging the Accounting Equation

It is common for this equation to be arranged into different formats. The most common arrangement of this equation is: Assets = Liabilities + Equity.

It can also be arranged to show: Liabilities = Assets – Equity.

Note that all three arrangements of the equation will get you to the exact same end point and are simply arranged to make the equation more simple in some cases. The basic formula at the top of this article is perhaps the easiest for a beginner to understand and make use of but can quickly be rearranged with the use of basic algebra.

Summary

The accounting equation is a quick way to check that all double entries into the accounting system have been made correctly and to the appropriate classifications of accounts. It will never show you exactly where an error has been made but is instead used as a building block to identify and work backwards to solve any problems.

It is crucial that the double entry system of accounting is understood before making use of the accounting equation and more advice around that system can be found at the link below:

https://www.accountingcoach.com/blog/what-is-the-double-entry-system